Mutual Fund Tax Trap

How to Escape the Mutual Fund Tax Trap

If you own actively managed mutual funds in your taxable accounts (something we don’t normally recommend), you may have a nasty tax surprise brewing: a big capital-gains tax hit when your funds make their annual capital gains distributions (usually in December).  A particularly unpleasant feature of holding mutual funds in your taxable account is that you are on the hook to pay your proportionate share of the fund’s tax liability every year—even if you did not sell any of your shares during that year!

Taking action to minimize (or eliminate) unwanted taxable capital gains distributions is just one thing you can do to reduce your tax bill and thereby improve your finances.  There are, however, many, many steps you can take to improve your overall finances.  And as we have written repeatedly in these pages, it is the accumulated and compounded effects of these many small, completed steps that ultimately translate into major improvements in your finances over time.

Mutual Fund Tax Bite Set to Get Worse

There are two reasons why capital gains distributions from mutual funds are set to get worse in the coming years.

First, there is a massive shift of money underway as investors have gotten wise to the tax headaches of mutual funds and are leaving them for lower-cost, tax-friendly exchange-traded funds (ETFs).  As an investor pulls money from a mutual fund, the fund’s portfolio manager is forced to sell assets to raise cash to meet redemption requests.  These asset sales are taxable events which may generate short- or long-term capital gains, upon which fund shareholders must pay tax.  And as mutual funds bleed assets, the remaining shareholders will be holding an increasingly large share of the funds’ taxable distributions to come in the future.

Second, U.S. stocks have performed very well in recent years.  This means that fund managers may not have a lot of unrealized losses in their funds that they can use to offset any capital gains they are realizing.  In the wake of the 2008-09 financial crisis, many funds had lots of unrealized losses that they were able to use over the succeeding years to offset capital gains.  However, this pool of potential losses has become much smaller as time has passed since the crisis, giving fund managers fewer options for offsetting gains.

What Can You Do?

If you own a U.S. equity mutual fund in a taxable account, it is likely that you have an unrealized gain in this holding due to the stock market’s excellent performance over recent years.  You have a couple of options, but unfortunately there is no painless and cost-free exit from a highly appreciated mutual fund held in a taxable account.  The first option is to simply continue to hold the fund.  In this case, you will have to continue paying capital gains taxes each year on the fund’s distributions well as continuing to pay the fund’s underlying expenses (e.g., management fees, marketing fees, etc.).  The second option is to sell your entire position (or a portion of it) now and pay the taxes, then find a more tax-friendly home for those assets so they have better growth potential for the future.

In the end, it is a question of whether to take some capital gains tax pain sooner by selling the fund outright or suffering more pain over a longer time frame by continuing to hold the fund and paying the requisite capital gains taxes each year.  It is up to each investor to decide which of these approaches is more palatable.

The good news is that once a tax-inefficient mutual fund position has been liquidated, there are many excellent tax-friendly options available to investors for putting their funds back to work.

If you would like our thoughts on how you might reduce your tax bill by employing prudent strategies such as swapping your tax-inefficient mutual funds for other investments, please don’t hesitate to give us a call or send us an email.

The content of this piece is for informational purposes only and is not tax advice.  For tax advice, individuals should consult their CPA.

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Peter Thoms, CFA, MBA

Peter Thoms, CFA, MBA

Peter Thoms, CFA, founded Orion Capital Management LLC in April 2002. Peter has extensive experience managing investment portfolios for clients pursuing a wide range of financial goals.

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